Measuring the Cost of Living 6 Measuring the Cost of Living

The Cost of Living We need all sorts of things to live These things are typically not free So, what’s the cost of living the way we actually live? That is, what’s the cost of buying the things we buy? CHAPTER 6 MEASURING THE COST OF LIVING

Why Do We Need to Know the Cost of Living? To see whether our incomes are keeping up with the cost of living CHAPTER 6 MEASURING THE COST OF LIVING

The Consumer Price Index The Consumer Price Index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. When the CPI rises, the typical family has to spend more dollars to maintain the same standard of living. The Bureau of Labor Statistics (BLS) reports the CPI each month. It is used to monitor changes in the cost of living over time. CHAPTER 6 MEASURING THE COST OF LIVING

http://research.stlouisfed.org/fred2/series/CPIAUCSL CHAPTER 6 MEASURING THE COST OF LIVING

How the CPI Is Calculated [BLS] Fix the basket: figure out what’s in the “basket” of goods that the typical consumer buys Find the prices paid by the typical consumer for the goods in the “basket” Compute the basket’s cost Choose a base year and compute the CPI for all years Compute the inflation rates for all years CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated Fix the basket: determine what “basket” of goods the typical consumer buys. The Bureau of Labor Statistics (BLS) identifies a market basket of goods and services the typical consumer buys. The BLS conducts monthly consumer surveys to set the weights for the prices of those goods and services. CHAPTER 6 MEASURING THE COST OF LIVING

FYI: What Is in the CPI’s Basket? [BLS] 17% Transportation 41% Housing 15% Food and beverages 7% Education and communication Medical care 7% Recreation 6% Apparel 4% Other goods and services 3% CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated Find the Prices: Find the prices of each of the goods and services in the basket at each point in time. CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated Compute the Basket’s Cost: Use the data on prices to calculate the cost of the basket of goods and services in different years. CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated Choose a Base Year and Compute the Index: Designate one year as the base year, making it the benchmark against which other years are compared. Compute the index by dividing the cost of the basket in one year by the cost of the basket in the base year and multiplying by 100. CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period. CHAPTER 6 MEASURING THE COST OF LIVING

Measuring the Cost of Living Inflation refers to a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated The Inflation Rate The inflation rate is calculated as follows: CHAPTER 6 MEASURING THE COST OF LIVING

http://research.stlouisfed.org/fred2/series/CPIAUCSL CHAPTER 6 MEASURING THE COST OF LIVING

How the Consumer Price Index Is Calculated: Another Example Base Year is 2002 Basket of goods in 2002 costs $1,200 The same basket in 2004 costs $1,236 CPI for 2004 = ($1,236/$1,200)  100 = 103 Prices increased 3 percent between 2002 and 2004 CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living The CPI is an accurate measure of the selected goods that make up the typical bundle, but it is not a perfect measure of the cost of living. CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living Substitution bias Introduction of new goods Unmeasured quality changes CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living: Substitution Bias The basket does not change to reflect consumer reaction to changes in relative prices. Consumers substitute toward goods that have become relatively less expensive. The index overstates the increase in cost of living by not considering consumer substitution. CHAPTER 6 MEASURING THE COST OF LIVING

Substitution Bias in CPI Suppose Red Apples and Green Apples are the only two commodities and are identical in taste. Suppose the typical consumer’s basket has, for many years, contained 10 of each type. Suppose the prices in 2005 (the base year) were $2 per apple for both types. So, the cost of the consumer’s basket was $40 in 2005. Suppose the prices in 2006 are $4 for a Red Apple and $2 for a Green Apple. So, the cost of the consumer’s basket is $60 in 2006. Therefore, the CPI for 2006 is (60/40) × 100 = 150, indicating a 50% increase in the cost of living But has the cost of living really increased? No. The consumer can switch to zero Red Apples and 20 Green Apples and enjoy the same satisfaction as always without any increase in cost. Therefore, the CPI exaggerates the true cost of living. CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living: Introduction of New Goods The basket does not reflect the change in purchasing power brought on by the introduction of new products. New products result in greater variety, which in turn makes each dollar more valuable. Consumers need fewer dollars to maintain any given standard of living. CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living: Unmeasured Quality Changes If the quality of a good rises from one year to the next, the value of a dollar rises, even if the price of the good stays the same. If the quality of a good falls from one year to the next, the value of a dollar falls, even if the price of the good stays the same. The BLS tries to adjust the price for constant quality, but such differences are hard to measure. CHAPTER 6 MEASURING THE COST OF LIVING

Problems in Measuring the Cost of Living The substitution bias, introduction of new goods, and unmeasured quality changes cause the CPI to overstate the true cost of living. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. The CPI overstates inflation by about 1 percentage point per year. CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index The GDP deflator is calculated as follows: CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index The BLS calculates other prices indexes: The index for different regions within the country. The producer price index, which measures the cost of a basket of goods and services bought by firms rather than consumers. [BLS] CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index Economists and policymakers monitor both the GDP deflator and the consumer price index to gauge how quickly prices are rising. There are two important differences between the indexes CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index The GDP deflator reflects the prices of all final goods and services produced domestically, whereas... …the consumer price index reflects the prices of all final goods and services bought by consumers. CHAPTER 6 MEASURING THE COST OF LIVING

The GDP Deflator Versus the Consumer Price Index The Consumer Price Index compares the price of a fixed basket of goods and services to the price of the basket in the base year (only occasionally does the BLS change the basket)... …whereas the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice If a Pennsylvania raises the price of rifles it sells to the U.S. Army, its price hikes will increase Both the CPI and the GDP deflator Neither the CPI nor the GDP deflator The CPI but not the GDP deflator The GDP deflator but not the CPI CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice If a Pennsylvania raises the price of rifles it sells to the U.S. Army, its price hikes will increase Both the CPI and the GDP deflator Neither the CPI nor the GDP deflator The CPI but not the GDP deflator The GDP deflator but not the CPI CHAPTER 6 MEASURING THE COST OF LIVING

Figure 2 Two Measures of Inflation Percent per Year 15 CPI 10 GDP deflator 5 1965 1970 1975 1980 1985 1990 1995 2000 CHAPTER 6 MEASURING THE COST OF LIVING

Correcting Economic Variables For The Effects Of Inflation Price indexes are used to correct for the effects of inflation when comparing dollar figures from different eras. See the BLS’s inflation calculator CHAPTER 6 MEASURING THE COST OF LIVING

Quick Quiz CPI in 1914 = 10 CPI in 2012 = 230 Henry Ford paid his workers $5 a day in 1914 Q: How much is that in 2012 dollars? CHAPTER 6 MEASURING THE COST OF LIVING

Quick Quiz CPI in 1914 = 10 CPI in 2012 = 230 Henry Ford paid his workers $5 a day in 1914 Q: How much is that in 2012 dollars? A: $115 CPI rose by a multiple of 23 (= 230/10) from 1914 to 2012 So, the 2012 equivalent of the 1914 salary would have to be 23 times higher = $5  23 = $115 CHAPTER 6 MEASURING THE COST OF LIVING

Correcting Economic Variables For The Effects Of Inflation If you know a dollar amount in year a, what is the equivalent dollar amount—in purchasing power—in year b? Year b amount=Year a amount× CPI in Year b CPI in Year a CHAPTER 6 MEASURING THE COST OF LIVING

Babe Ruth’s Salary CPI in 1931 = 15.2 CPI in 2012 = 229.5 Therefore, prices rose by a multiple of 229.5/15.2 = 15.1 over the period Babe Ruth earned $80,000 in 1931 The equivalent salary in 2012 is, therefore, 15.1 times his 1931 salary, or $80,000 ✕ 15.1 = $1,207,894 CHAPTER 6 MEASURING THE COST OF LIVING

Table 2 The Most Popular Movies of All Times, Inflation Adjusted CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice If the consumer price index is 200 in the year 1980 and 300 today, then $600 in 1980 has the same purchasing power as ___ today. $400 $500 $700 $900 CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice If the consumer price index is 200 in the year 1980 and 300 today, then $600 in 1980 has the same purchasing power as ___ today. $400 $500 $700 $900 As prices have risen by a multiple of 1.5 (= 300/200) since 1980, any amount in 1980 dollars must increase by a multiple of 1.5 in order to have the same purchasing power CHAPTER 6 MEASURING THE COST OF LIVING

Indexation When some dollar amount is automatically corrected for inflation by law or contract, the amount is said to be indexed for inflation. CHAPTER 6 MEASURING THE COST OF LIVING

Real and Nominal Interest Rates Interest represents a payment in the future for a receipt of money in the past. CHAPTER 6 MEASURING THE COST OF LIVING

Real and Nominal Interest Rates The nominal interest rate is the interest rate usually mentioned in borrowing or lending contracts. It is not corrected for inflation. It is the interest rate that a bank pays. The real interest rate is the interest rate that is corrected for the effects of inflation. CHAPTER 6 MEASURING THE COST OF LIVING

Real and Nominal Interest Rates You borrowed $1,000 for one year Nominal interest rate was 15% During the year, inflation was 10% Real interest rate = Nominal interest rate – Inflation = 15% - 10% = 5% CHAPTER 6 MEASURING THE COST OF LIVING

Figure 3 Real and Nominal Interest Rates (percent per year) 15% Nominal interest rate (3-month Treasury Bills) 10 5 Real interest rate 5 1965 1970 1975 1980 1985 1990 1995 2000 2005 CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice You deposit $2,000 in a savings account, and a year later you have $2,100. Meanwhile, the consumer price index rises from 200 to 204. In this case, the nominal interest rate is ___ percent, and the real interest rate is ___ percent. 1; 5 3; 5 5; 1 5; 3 CHAPTER 6 MEASURING THE COST OF LIVING

Quick Check Multiple Choice You deposit $2,000 in a savings account, and a year later you have $2,100. Meanwhile, the consumer price index rises from 200 to 204. In this case, the nominal interest rate is ___ percent, and the real interest rate is ___ percent. 1; 5 3; 5 5; 1 5; 3 CHAPTER 6 MEASURING THE COST OF LIVING

Summary The consumer price index shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate. CHAPTER 6 MEASURING THE COST OF LIVING

Summary The consumer price index is an imperfect measure of the cost of living for the following three reasons: substitution bias, the introduction of new goods, and unmeasured changes in quality. Because of measurement problems, the CPI overstates annual inflation by about 1 percentage point. CHAPTER 6 MEASURING THE COST OF LIVING

Summary The GDP deflator differs from the CPI because it includes goods and services produced rather than goods and services consumed. In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically changes the group of goods and services over time as the composition of GDP changes. CHAPTER 6 MEASURING THE COST OF LIVING

Summary Dollar figures from different points in time do not represent a valid comparison of purchasing power. Various laws and private contracts use price indexes to correct for the effects of inflation. The real interest rate equals the nominal interest rate minus the rate of inflation. CHAPTER 6 MEASURING THE COST OF LIVING